The West is facing a new era of financial repression

Direct or indirect monetary financing of budget deficits used to rank among the gravest sins that a central bank could commit — ‘quantitative easing’ is a new incarnation of this old transgression

By Sylvester Eijffinger and Edin Mujagic /

Mon, Nov 26, 2012 - Page 9

Following his re-election, US President Barack Obama almost immediately turned his attention to reining in the US’ rising national debt. In fact, almost all Western countries are implementing policies aimed at reducing — or at least arresting the growth of — the volume of public debt.

In their widely cited paper Growth in a Time of Debt, Kenneth Rogoff and Carmen Reinhart argue that, when government debt exceeds 90 percent of GDP, countries suffer slower economic growth. Many Western countries’ national debt is now dangerously near, and in some cases above, this critical threshold.

Indeed, according to the Organisation for Economic Co-operation and Development, by the end of this year, the US’ national debt/GDP ratio will climb to 108.6 percent. Public debt in the eurozone stands at 99.1 percent of GDP, led by France, where the ratio is expected to reach 105.5 percent and the UK, where it will reach 104.2 percent. Even well disciplined Germany is expected to close in on the 90 percent threshold at 88.5 percent.

Countries can reduce their national debt by narrowing the budget deficit or achieving a primary surplus (the fiscal balance minus interest payments on outstanding debt). This can be accomplished through tax increases, cuts to government spending, faster economic growth or some combination of these components.

When the economy is growing, automatic stabilizers work their magic. As more people work and earn more money, tax liabilities rise and eligibility for government benefits such as unemployment insurance falls. With higher revenues and lower payouts, the budget deficit diminishes.

However, in times of slow economic growth, policymakers’ options are grim. Increasing taxes is not only unpopular, it can be counterproductive, given already-high taxation in many countries. Public support for spending cuts is also difficult to win. As a result, many Western policymakers are seeking alternative solutions — many of which can be classified as financial repression.

Financial repression occurs when governments take measures to channel to themselves funds that, in a deregulated market, would go elsewhere. For example, many governments have implemented regulations for banks and insurance companies that increase the amount of government debt that they own.

Consider the Basel III international banking standards. Among other things, Basel III stipulates that banks do not have to set aside cash against their investments in government bonds with ratings of “AA-” or higher. Moreover, investments in bonds issued by their home governments require no buffer, regardless of the rating.

Meanwhile, Western central banks are using another kind of financial repression by maintaining negative real interest rates (yielding less than the rate of inflation), which enables them to service their debt for free.

The policy rate of the European Central Bank (ECB) stands at 0.75 percent, while the eurozone’s annual inflation rate is 2.5 percent. Likewise, the Bank of England keeps its policy rate at only 0.5 percent, despite an inflation rate that hovers above 2 percent, while in the US, where inflation exceeds 2 percent, the Federal Reserve’s benchmark federal funds rate remains at an historic low of 0 percent to 0.25 percent.

Moreover, given that the ECB, the Bank of England and the Fed are venturing into capital markets — via quantitative easing (QE) in the US and the UK, and the ECB’s “outright monetary transactions” (OMT) program in the eurozone — long-term real interest rates are also negative (the real 30-year interest rate in the US is positive, but barely).

Such tactics, in which banks are nudged, not coerced, into investing in government debt, constitute “soft” financial repression, but governments can go beyond such methods, demanding that financial institutions maintain or increase their holdings of government debt, as the UK’s Financial Services Authority did in 2009.

Similarly, last year, Spanish banks increased their lending to the government by almost 15 percent, even though private-sector lending contracted and the Spanish government became less creditworthy.

A senior Italian banker once said that Italian banks would be hanged by the Italian Ministry of Finance if they sold any of their government-debt holdings and a Portuguese banker declared that, while banks should reduce their exposure to risky government bonds, government pressure to buy more was overwhelming.

In addition, in many countries, including France, Ireland and Portugal, governments have raided pension funds in order to finance their budget deficits. The UK is poised to take similar action, “allowing” local government pension funds to invest in infrastructure projects.

Direct or indirect monetary financing of budget deficits used to rank among the gravest sins that a central bank could commit. QE and OMT are simply new incarnations of this old transgression.

Such central-bank policies, together with Basel III, mean that financial repression will likely define the economic landscape for at least another decade.

Sylvester Eijffinger is professor of financial economics at Tilburg University in the Netherlands. Edin Mujagic is a monetary economist at Tilburg University.